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By Andrea Chan & Gary Marcus
Published March 1, 2010
Publication: Ontario Dentist (Adobe PDF Document) (262KB)
The majority of dentists intend to sell their practices to fund retirement. Those who have not incorporated may view succession planning as unnecessary. But, as the following case study demonstrates, succession planning can save the retiring dentist hundreds of thousands of dollars, ensure retirement occurs at the desired time and potentially increase the value of the practice and the subsequent profit when the practice is sold.
Dr. Todd Smith* has been practising dentistry for more than 20 years in a large Ontario city. He is married and has one child, a daughter Belinda who just celebrated her 18th birthday. Dr. Smith owns an unincorporated dental practice and his wife Louisa is a dental hygienist who owns an incorporated hygiene practice. After expenses, the practices earn about $550,000 in total. Both professionals use the entire $550,000 in annual income for the family’s living expenses. Recently, the combined practice assets were appraised at $950,000. Of this, $850,000 is attributed to the
dental practice and $100,000 to the hygiene practice. The Smiths have never spoken to an accountant about succession planning, until now.
Dr. Smith wants to retire as soon as possible by selling his practice. Minimizing taxes is a priority for the couple. Selling the assets of the practices will result in a tax bill of at least $174,000
Dr. and Mrs. Smith have never used their lifetime capital gains exemptions of $750,000 each ($1,500,000 in total). This means if Dr. Smith incorporated his practice and sold shares of the corporation instead of the practice assets, he and his wife could use their combined capital gains exemptions and receive up to $1.5 million in profit from the sale of the practice, without having to pay any tax.
However, in the past, Dr. Smith invested in tax shelters. These investments resulted in a $750,000 cumulative net investment loss (CNIL). When an individual claims cumulative investment expenses in excess of investment income, that person’s access to the capital gains exemption is reduced. Dr. Smith’s $750,000 CNIL balance is preventing him from using his capital gains exemption for a tax-free sale. Even if he sells shares instead of assets, he will have to pay a minimum of $174,000 in taxes.
Dr. Smith is advised to wait another two years to sell his practice, because he needs time to execute our tax elimination plan. The first step is to reorganize his corporate structure, transferring his
unincorporated practice into his wife’s hygiene company then converting that into a professional corporation. The transfer of the practice to the hygiene company is done through a purchase and sale agreement between Dr. Smith and the company. This sale of the practice is done on a taxfree basis by filing an election under section 85(1) of the Income Tax Act with CRA. This new combined entity has the following shareholders: Dr. Smith, Mrs. Smith and their daughter Belinda. With this structure they have the ability to take advantage of lower corporate tax rates in conjunction
with income splitting with the familymember shareholders.
The solution to Dr. Smith’s CNIL problem is to pay himself dividends from the corporation through redemption of some of the shares he received when he sold his practice to the hygiene company. When entered on Dr. Smith’s personal tax return, the dividends would be grossed up by 25 percent. He would then get a 16.6 percent dividend tax credit; the $600,000 dividend would create taxable investment income of $750,000, which directly offsets Dr. Smith’s current $750,000 negative CNIL position. The corporation will also pay dividends toMrs. Smith and Belinda, in order to do some income splitting over the next two years. For example, Belinda who is just starting university can earn this additional $25,000, and pay only a minimal amount of tax.
Two years later, Dr. Smith was able to sell the shares of the professional corporation for $1,050,000. This was $100,000 more than the original appraisal. The Smiths were pleased with the outcome of their tax elimination plan, but had to work two years longer than originally planned. If they had begun succession planning earlier, the issues would have been identified immediately,
and the corporate structure could have been reorganized at that time to achieve the same result sooner.
Andrea Chan, CA, and Gary Marcus, CA, CPA, are tax advisors with Meyers Norris Penny LLP. They may be contacted at 416.596.1711.
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